Office Market: Solid and Steady in Q3

National Market Overview

Office Market

The US office market recorded another vacancy decline of 10 basis points to 10.6% in Q3, after posting 10 point declines in each of the three previous quarters. However, most of the activity is concentrated in a handful of major markets, with secondary markets across the country making more modest gains. In the past four quarters, the overall vacancy rate has moved down by 30 basis points, and with so much of the activity concentrated in bigger transactions, larger blocks of space are becoming harder to find in hot markets like San Francisco and New York where growth in the TAMI sector has boosted job creation and sent rents to record highs.

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The construction of new office product has been surprisingly consistent. In each of the past four quarters, deliveries came in between 18 and 20 million square feet. In Q3, 321 buildings totaling 18.8 million square feet were added to the US office base, which now stands at nearly 10.6 billion square feet. Another 139.7 million square feet was underway by the end of Q3. Given vacancy’s gradual and consistent decline, it appears that new construction is balanced well with overall leasing activity. Central Business Districts in both primary and secondary markets are seeing the most development activity. Urban cores offer the population density for developers to be successful in building mixed-use projects with a balance of office, retail and residential components, a factor that is attractive to the growing millennial workforce. Speculative development activity is still strong due to optimistic forecasts for rent growth and net absorption, but in secondary markets lenders are more insistent on substantial pre-lease commitments to fund new projects. Energy markets like Houston, which was seeing strong development activity, are now experiencing a hold on new projects, as developers wait for the end of the energy slump.

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Net absorption has also been consistently positive. In Q3 the gain in occupied space hit almost 35.7 million square feet, following a 30.54 million square feet in Q2. In the past four quarters nearly 117 million square feet of net absorption has been recorded. It is important to note, however, that big build-to-suit deals have accounted for a significant chunk of net absorption in energy markets year-to-date. That activity has come to a temporary halt, which will impact absorption going forward. Class A space accounted for just over half the net absorption total for the quarter, just as it did in Q2. Users across the board are looking to gain greater efficiencies by leveraging communication technologies and move to more open space design to reduce the square footage allocated to each employee. This allows them to pay more per square foot for higher quality locations that offer the amenities preferred by their workers.

Average asking lease rates for the US moved up another $.19 in Q3 to $23.09 per square foot. While rent increases were recorded in most markets around the US, bigger markets with concentrations of TAMI and healthcare services firms are seeing rents move up faster, especially in more urban locales. As a result, markets like Seattle and San Francisco have been experiencing big rent spikes recently, while energy-based markets like Houston are seeing rent growth level off and vacancy move up due to higher amounts of sublease space.

Sales activity across the full spectrum of office product has been and remains robust. Institutions and private investors both large and small, foreign or domestic, are bullish on the long term potential of the office sector in terms of occupancy and rent growth. Cap rates have fallen to historic lows with prime office properties trading below 5%. Foreign buyers keep money flowing into the US because of the stability of our economy relative to the rest of the world. This has put further pressure on cap rates for office properties in both primary and secondary markets. The tolerance for risk has gone up as a result and investors at all levels are showing more interest in value-add opportunities that might offer higher yields. This has given secondary markets a big boost, and even though cap rates are higher than markets like New York, Los Angeles and San Francisco, they are moving lower across the board.

A Look Ahead

The US office market should remain strong going into 2016. Overall growth for office-using businesses is broad-based and current market metrics generally point to further gains for the overall office market. But, job growth is what drives net absorption and the last few jobs reports for the US have been disappointing. After averaging over 200,000 new jobs per month for more than a year, August and September reported less than 150,000 new positions for those two months. With major layoffs in the energy sector becoming commonplace, other sectors will have to pick up the hiring pace to keep things moving forward in the longer term. It’s too early to tell just yet if overall job growth is slowing in the long term, but industry experts are beginning to talk more openly about the next market peak coming sooner rather than later. Despite that chatter, average asking lease rates continue to move higher, vacancy keeps moving lower and net absorption remains positive in all but a very few markets. Developers are showing enough restraint not to overbuild and lenders are sticking to rigorous underwriting criteria. But, there is no denying that the current recovery lacks momentum and the global economy has temporarily stalled out. That breeds uncertainty and uncertainty leads to delays in expansion plans for businesses big and small. The next few jobs reports will give us a better handle on the direction of the office market for 2016 and beyond.

Michael Staskiewicz, CCIM is the Managing Principal of Effective Realty Advisors and Founder of EffectiveWorkplace.com.
Michael helps innovative, purpose-driven CEOs clarify the strategic plan for a world-class work environment, so they can attract the best talent and reduce voluntary turnover.

EffectiveWorkplace.com is a resource for CEOs, Business Owners, and Executive Leaders of mid-sized companies that helps them build, optimize, and transform their workplace. It was founded by Michael Staskiewicz, CCIM, Managing Principal of Effective Realty Advisors.

Michael helps innovative, purpose-driven CEOs clarify the strategic plan for a world-class work environment, so they can attract the best talent and reduce voluntary turnover.